Cost of Preference Shares and Convertibles

Between debt and equity lie two instruments that share features of both. A preference share promises a fixed dividend, ranks before ordinary shares and has no vote, yet is not a loan. A convertible bond pays interest like debt but can be exchanged for shares if the company does well, so it offers the investor safety now and a share in the upside later.

Companies issue them for different reasons: preference shares to raise money without adding to borrowing or giving up votes, convertible bonds to borrow at a lower coupon by giving the lender a free option. Their cost is not obvious, because the cost of a preference share has no tax relief and the cost of a convertible depends on what the shares will be worth on the conversion date.

This topic explains how to calculate the cost of preference shares, the terms and values of a convertible bond (the conversion ratio, price and value, the straight value, the minimum value and the conversion premium), how a share split changes the terms, how to calculate the cost of a convertible, and how to choose between these instruments, with worked examples.

The next topic combines all the costs of capital into the weighted average cost of capital.

The terms and values of a convertible bond, including the conversion ratio after a stock split, the conversion value, the straight value, the premium and the minimum value, were the subject of May Diet, 2026, Question 7 (15 marks). Read cost of debt first.

Preference shares

Preference shares pay a fixed dividend that must be paid before any ordinary dividend, and in a liquidation they are repaid before ordinary shareholders (but after lenders). They usually carry no vote unless the dividend is in arrears. The main variations are: cumulative (unpaid dividends accumulate and must be paid before ordinary dividends), redeemable (repaid at a set date) or irredeemable, and participating (sharing in extra profits) or convertible.

They are less common among listed companies than ordinary shares and bonds, and dividends are paid from distributable profit only, which makes them less certain than interest.

Cost. Dividends on preference shares are not tax-deductible, so the cost is calculated ignoring tax, like the cost of equity. For irredeemable preference shares the cost is dividend ÷ price, as for a constant dividend: an 11% preference share of ₦1 nominal priced at ₦0.90 costs 0.11 ÷ 0.90 = 12.2%.

For redeemable preference shares the cost is the IRR of the price (outflow), the annual dividends and the redemption value: a share priced at ₦88 paying ₦9 a year for four years and redeemed at ₦105 has an IRR of 14.1%. Because there is no tax relief, preference shares cost more than debt of similar risk (a 14% loan costs 14% × 0.70 = 9.8% after tax) but less than ordinary equity, since preference holders have a fixed, prior claim.

Terms and values of a convertible bond

A convertible bond gives the holder the right, at a stated date or dates, to exchange the bond for a stated number of ordinary shares, or to take repayment. Take a bond of ₦1,000 nominal with a 10% coupon, redeemable in five years, convertible into 250 shares. The ordinary share price is ₦3.60 and the bond trades at ₦1,040. Also, similar straight bonds yield 14%.

• Conversion ratio: the number of shares per bond: 250.
• Conversion price:
  nominal value ÷ conversion ratio = 1,000 ÷ 250 = ₦4.00 a share.
  (The holder gets shares at ₦4.00 effectively; it is worth converting only if the share price rises above this.)
• Conversion value.
  (current): ratio × share price = 250 × 3.60 = ₦900: what the bond would be worth if converted today.
• Straight value:
  the value of the bond as ordinary debt, ignoring the option: the present value of ₦100 a year for five years and ₦1,000 at redemption at 14% = 100 × 3.433 + 1,000 × 0.519 = 343.3 + 519.4 = ₦862.7.
• Minimum (floor) value: the higher of the straight value and the conversion value, since the bond cannot be worth less than either: ₦862.7.
• Conversion premium:
  the market price less the conversion value = 1,040 − 900 = ₦140, or 140 ÷ 900 = 15.6%
  per share it is the effective price paid, 1,040 ÷ 250 = ₦4.16, less the share price of ₦3.60, ₦0.56 (15.6%).
  The premium pays for the option of waiting to see whether the shares rise, and for the downside protection of the straight value.

The effect of a share split

If the ordinary shares are split two for one, each share becomes two shares and the share price halves. The conversion ratio doubles to 500 and the conversion price halves to ₦2.00, the share price becomes ₦1.80, and the conversion value is 500 × 1.80 = ₦900, unchanged. A split changes the numbers, not the value. Share splits and bonus issues are adjusted in the terms for this reason.

Why the issuer uses a convertible, and the risks

• Lower coupon: investors accept less interest in return for the option, so a convertible costs less in cash than straight debt.
• Cheap equity later: if conversion happens the debt disappears and the company has new shares without issue costs, and, if the price has risen, at a higher price than it could have sold them at today.
• Risks: if the share price does not rise, the bond is not converted and must be repaid (a refinancing burden); if it does, the existing shareholders are diluted at the conversion price, below the market price at that time. Gearing falls on conversion.

The cost of a convertible bond

The cost to the company, as seen earlier for debt, is the higher of (a) the cost as a straight bond redeemed at maturity and (b) the IRR assuming conversion, because the holder will choose the better of the two. For (b) use the expected share price at conversion.

Continuing the example, the share price is expected to grow 8% a year, so after five years it will be 3.60 × 1.08⁵ = ₦5.29 and the conversion value 250 × 5.29 = ₦1,322, well above the redemption value of ₦1,000, so holders will convert. With net interest of ₦70 a year (after tax at 30%), the cash flows are −1,040, then +70 a year, with 70 + 1,322 in year 5: the IRR is 11.1%. As a straight bond the IRR would be only 6.0%.

The cost is therefore 11.1%. If the shares were expected to be worth less than the redemption value at the conversion date, the bond would be repaid and the cost would be the straight-bond figure. A convertible with a conversion value expected well above redemption is really a deferred equity issue, and its cost is close to that of equity.

Choosing between instruments

The ideas in more depth

Why the convertible is worth more than either part

A convertible is a straight bond plus an option to buy shares at the conversion price. The option has value even when the shares are below the conversion price, because the shares might rise. So the market price is above both the straight value and the conversion value, and the gap over the conversion value is the premium.

As the shares rise the conversion value approaches and then exceeds the market price, and the bond behaves like the shares; as they fall, the straight value acts as a floor, and the bond behaves like debt.

Why the cost is the higher of the two

The holder chooses at the conversion date. If shares are worth more than the redemption value, the holder converts, and the company gives up shares worth that value; if not, it repays. Whichever the holder chooses, it is the more expensive of the two outcomes for the company, so the cost is the higher IRR.

Sources and references

• For the accounting of preference shares and convertible bonds see International Accounting Standard (IAS) 32 Financial Instruments: Presentation, which splits a convertible into a liability and an equity part; the Companies and Allied Matters Act 2020 on the issue and conversion of securities; the Investments and Securities Act 2025 and the Securities and Exchange Commission rules on public offers of convertibles.

These points are stated as at 5 November 2026.

Worked examples

1. Conversion price.
   1,000 ÷ 250 = ₦4.00.
2. Conversion value.
   250 × 3.60 = ₦900
   premium 1,040 − 900 = ₦140.

1. Cost.
   0.11 ÷ 0.90 = 12.2% (no tax relief).

1. Ratio.
   2 × 250 = 500 shares; price ₦2.00.
2. Value.
   500 × 1.80 = ₦900, unchanged.

How to answer in the exam

• Define each term and calculate it from the data, one line each.
• Adjust for a split by changing the ratio and the price together.
• For cost, forecast the share price, compute the conversion value and compare it with the redemption value before choosing the IRR.
• Discuss risks to the issuer: dilution, refinancing and gearing.

Common mistakes in the exam

• Giving preference share dividends tax relief.
• Confusing the conversion price with the share price.
• Using the straight bond cost for a bond that will be converted.
• Forgetting to adjust the ratio and the price for a share split.
• Calculating the premium against the nominal value instead of the conversion value.
• Stating the minimum value as the lower of the two values.

Quick revision

• Preference: dividend ÷ price, or IRR; no tax relief.
• Conversion price = nominal ÷ ratio; conversion value = ratio × share price.
• Floor = higher of straight and conversion value; premium = price − conversion value.
• Cost of a convertible = higher of straight-bond cost and conversion IRR.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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